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Crowdfunding: 5 Things You Should Know

New crowdfunding sites are springing up every month and more and more entrepreneurs are looking to these sites for money. Despite all the hoopla, crowdfunding is not currently a good alternative for most start-up or small businesses. Here are five things you should know about crowdfunding.

Projects, Not Businesses

The majority of crowdfunding sites cater to one-time creative or charitable projects, not ongoing businesses. The funding comes in the form of donations. The funders may get some type of reward — such as books, or invitations to films or concerts — related to the projects. But they do not get their money back. Two of the most successful sites that serve the creative market are Kickstarter and IndieGoGo.

Most of the projects request and receive a relatively small amount of funding, usually no more than $100,000 and sometimes considerably less. That’s hardly enough to fund a business that requires inventory, office, or warehouse space.

All Is Not Well in Crowdfunding Land

Some sites have disappeared; some companies have non-functional websites or websites that have not been updated since 2010. Among them are ChipIn, 33needs, Cofundus, and RaiseCapital.com.

Before submitting a project, it is a good idea to contact the crowdfunding company by phone or email to make sure it is still operational. There are a fixed number of people interested in investing this way and the demise of some websites may signal that too many intermediaries exist for the number of funders available.

Legal Issues

Equity crowdfunding — the expectation of getting a payback on an investment — is actually illegal in the United States. In “Need Funding for Your Company? Look Online,” I mentioned that the U.S. Securities and Exchange Commission considers crowdfunding to be a sale of securities, which would require that the crowdfunding website owners be registered as brokers. One site, MicroVentures, is a registered broker. Two others sites, GrowVC and SeedUps, have headquarters outside the United States, making them exempt from U.S. law. Other sites are in a gray area, saying that they only provide a meeting place for entrepreneurs and equity funders.

One prominent crowdfunder, California-based ProFounder, was recently forced to cease operations by state authorities. “They were acting as a broker without being licensed as a broker dealer,” stated Preston DuFauchard, the commissioner for the California Department of Corporations. In August, the state agency issued a formal consent order to ProFounder to “desist and refrain” from engaging in securities transactions without registering as a broker dealer. Other states may not be as diligent as California, but all crowdfunding sites with an equity model are subject to SEC enforcement. ProFounder is now actively lobbying for changes to the securities law.

New Crowdfunding Legislation

Many observers believe that equity crowdfunding is a good way to help entrepreneurs and small businesses start and grow. But crowdfunding sites maintain that high costs and burdensome compliance requirements are deterrents to becoming licensed brokers. For example, the sites must not only register with the Securities and Exchange Commission through the Financial Industry Regulatory Authority, but also in every state where they plan to do business.

The SEC signaled several months ago that it was willing to take a fresh look at its rules for broker registration, which were enacted in — and have not been changed since — the Depression. And last month, the House of Representatives passed the Entrepreneur Access to Capital Act — described at WashingtonWatch.com — which makes it easier for businesses to raise capital through crowdfunding. The legislation allows businesses to use crowdfunding to sell unregistered securities so long as the total amount raised does not exceed $1 million, or $2 million if the company provides potential investors with audited financial statements. Individual investments are limited to $10,000 or 10 percent of an investor’s annual income, whichever is less. The House bill provides some protection for investors from fraudulent offerings and state regulators will be notified of each crowdfunding offering. Also, people who have been convicted of securities fraud or other financial crimes will be prohibited from raising money through crowdfunding. In addition, the offerings will include warnings about the speculative nature of investing in startups. The legislation would supersede any state requirements for broker registration.

Earlier this month U.S. Senator Scott Brown of Massachusetts introduced a measure in the Senate similar to the House bill, but which restricts investors to a maximum investment of $1,000 on an offering of no more than $1 million. As the effort to allow equity crowdfunding has bipartisan support, a bill that will exempt limited equity investments in small businesses from securities regulation will likely become law early next year.

Downside to Equity Crowdfunding?

While crowdfunding would provide another source of equity funding for small businesses, there are several potential drawbacks for entrepreneurs. Unlike contributions to one-off projects in which donors have no say in implementation, equity investors want, and are entitled to, some influence in the direction a business takes. Having hundreds of equity investors means you will be answering to hundreds of bosses. That’s time-consuming and costly to administer.

Moreover, startups that accept equity crowdfunding can expect to have difficulty raising additional funds from venture capital firms and other sophisticated investors if they have hundreds of small, less knowledgeable backers.

Practical Ecommerce is an independent, family-owned, online magazine in Traverse City, Michigan, U.S. We are not affiliated with any e-commerce service, platform, or provider. Our mission is to publish authoritative articles, commentary, webinars, and podcasts to help online merchants.